Asian Financial crises
Chapter

Chapter 32 Moral Hazard is Avoidable

Author(s):
International Monetary Fund
Published Date:
January 2001
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The international financial system is at a crossroads. We can conclude from the recent crises that markets do not work and that more government interventions, capital controls, and bailouts are needed, or we can conclude (correctly) that the incentive problems fostered by government and International Monetary Fund protection of banks and conglomerates, an absence of basic rule of law in many countries, and other core weaknesses of government policy are at the heart of recent financial fragility (Calomiris, 1998a). The latter approach is the more difficult path, since it implies a need for fundamental reform that will be politically difficult.

I want to discuss my admittedly ambitious proposal for reform of the so-called global financial architecture, and the IMF in particular (Calomiris, 1998b). I offer an economist’s perspective on the central issue of the current policy debate: Can we provide preventative and responsive liquidity protection without undermining the core incentives of the market economy, as we have been doing with bailouts? I argue that even if we begin with an encompassing definition of “liquidity” problems, we can design institutions that resolve those liquidity problems without giving rise to the social costs that come from counterproductive bailouts of insolvent banks by domestic governments and the IMF.

It is not difficult to construct a set of mechanisms that resolve at the same time problems of illiquidity (by providing a responsive international lender of last resort facility alongside a domestic deposit insurance system) while avoiding the governance and incentive problems attendant to counterproductive bailouts of risk takers by ensuring credible market discipline of financial institutions. The hurdles that must be overcome in designing an appropriate financial architecture, then, are not those posed by economics, but rather by politics. The challenge is to get those with vested interest in the current allocation of political power—including bankers, developing country oligarchs, and the U.S. Treasury—to relinquish some of the power they currently wield in order to make the global financial system more efficient, competitive, and democratic.

My proposal focuses on the need to restore proper incentives in banking systems as a prerequisite to providing liquidity protection. Many others talk about the need for proper “transparency” or improved government supervision of banks. But I place my faith in private incentives. All the information in the world about bank risk is useless if there is no incentive to use it properly to rein in bank risk taking. And government supervision, while certainly necessary, is not a dependable alternative to private discipline, as the behavior of supervisors has illustrated now in scores of cases of banking system collapse. Furthermore, credible market discipline is a lever for other reforms. It will create a strong constituency for transparency and reforms to legal systems, and market signals about bank quality can limit politically motivated supervisory forbearance. The key to real reform is to place market discipline at the top of the list.

In tackling the moral hazard problem the biggest challenge we must confront is the lack of discipline over bank risk choices. Banks are allowed, and often encouraged, to increase their risk, particularly in response to adverse macroeconomic shocks. Before banks were protected by government safety nets, economic downturns produced immediate contractions of bank credit supply and cuts in bank dividends, as banks scrambled to reassure depositors that bank loan losses would not result in losses for depositors (Calomiris and Wilson, 1998).

Safety net protection has removed that important disciplinary check on bank behavior. Safety net protection (ultimately, taxpayer protection of banks and their claimants) relaxes market discipline on bank risk taking and subsidizes higher risk in banks. This effect is especially pronounced after banks experience initial losses to the value of their assets. In the wake of such losses, safety net protection encourages banks to consciously increase their asset risk. Those increases in risk often take the form of increased default risk and exchange rate risk after banks have already seen severe depletion of their capital.

Without a reliable means of bringing credible market discipline to bear on banks, to provide strong incentives for prudent risk management, government deposit insurance and IMF lending will spur excessive risk taking, financial collapse, and it attendant costs. But in the presence of credible market discipline, deposit insurance and IMF lending (if structured properly) can strengthen the financial system by helping to avoid liquidity crises, which result either from problems of asymmetric information or self-fulfilling expectations.

The two most important liquidity problems are (1) banking panics that result from temporary confusion on the part of bank debt holders about the incidence within the banking sector of losses resulting from observable macroshocks, and (2) self-fulfilling collapses of currencies that result from government illiquidity. To solve the first problem, I propose a set of banking regulations that together would remove the threat of banking panics—including (1) capital standards founded on market discipline, achieved through a requirement that banks maintain a minimal proportion of uninsured, junior (or subordinated) debt with a maximum credit risk spread; (2) credible deposit insurance for other bank debt claims; (3) a twenty percent cash (or equivalents) reserve requirement for banks; (4) a twenty percent “global securities” requirement for banks; (5) free entry by domestic and foreign competitors into banking; and (6) limitations on other government assistance to banks.

It is important to emphasize that a broad consensus has emerged on the need to add some form of subordinated debt requirement to the Basle capital standards as the best means to ensure credible market discipline of banks. Advocates of such a requirement now include: The Bankers’ Roundtable, the U.S. Treasury, several Federal Reserve Bank Presidents, at least one Fed Governor, some members of Congress, and the Shadow Financial Regulatory Committee. I congratulate the Federal Reserve Board on assembling a task force to explore the question of how best to design and implement a subordinated debt requirement.

The combination of domestic deposit insurance and market discipline (which prevents the abuse of deposit insurance) can resolve the threat of banking panics that result either from confusion about the incidence of shocks, or self-fulfilling concerns about he insufficiency of bank reserves. The IMF’s role would be mainly to address the other liquidity problem—liquidity crises that face member governments as the result of unwarranted speculative pressure on exchange rates. This was the original intent of the IMF’s founders, and it remains a legitimate objective of IMF policy.

Recent studies that emphasize the value of IMF liquidity protection argue that the current form of IMF assistance is inadequate—it is too little, too late, and with too many conditions and delays to be effective in short-circuiting self-fulfilling runs on currencies or government debt. But how does one provide effective liquidity protection without encouraging counterproductive bailouts of banks and/or governments?

My plan (which in many respects mirrors the recent reform proposal of Meltzer, 1998) is to replace the current IMF and Exchange Stabilization Fund with a new IMF, which would offer a discount window lending facility. That facility would only be available to IMF members—and membership would require adherence to the aforementioned banking regulations, as well as some additional rules regarding government debt management, and (if a fixed exchange rate is maintained) a twenty-five percent minimum reserve requirement for the central bank and a requirement that banks offer accounts denominated in both domestic and foreign currency. By restricting access to the IMF window to members in good standing who conform to a few, simple, and easily verified rules, the IMF avoids free-riding on liquidity protection, and the hazard of unwittingly financing bank bailout in the guise of liquidity protection.

The rules governing the discount window follow Walter Bagehot’s classic principles for ensuring liquidity, while avoiding free riding: lend freely on good collateral at a penalty rate. The specifics of membership rules, limits on collateral, and penalty lending rates (summarized in Table 1) encourage member countries’ central banks (like their commercial banks) to reduce the risk of their securities portfolios and maintain adequate liquid reserves. If a member is in good standing, loans are made available on good collateral using one-week-old prices to value collateral. The loan interest rate is set at two percent above the value-weighted yield to maturity on the collateral offered. That provides a fast and effective means to short-circuit a self-fulfilling “bad equilibrium.”

In implementing reform, the devil is in the details, hence my emphasis on “blueprints” (specific concrete proposals) rather than simply organizing principles. Slight differences in details can make the difference between a reform agenda that achieves both liquidity and proper incentives toward risk taking, and one that achieves neither.

Table 1Elements of the Reform Plan
Membership Criteria for the IMF
Bank regulations:
Basle standards (but without restrictions on subordinated debt/tier 2 capital)
2 percent subordinated debt requirement (with rules on maturities, holders, and yields)
20 percent cash reserve requirement
20 percent “global securities” requirement
Free entry by domestic and foreign investors into banking
Bank recapitalizations are permitted, but strict guidelines must be met (and must follow pre-established rules, as in preferred stock matching program)
Domestic lenders of last resort avoid bank bailouts by following Bagehotian principles
Other membership criteria:
Limits on short-term government securities issues
If fixed exchange rate, 25 percent minimum central bank reserve requirement
If fixed exchange rate, banks offer accounts in domestic and foreign currencies
IMF Lending Rules
Loans are provided only to members in good standing (those following above rules)
If a member defaults, it may not borrow for 5 years, and then only after arrears paid
Loans are for 90 days
Supernumerary majority of members required to roll over loans for another 90 days
Loans are collateralized by 125 percent of value of loan in government securities
25 percent of the 125 percent collateral must be in foreign government securities
The interest rate on the loan is set at 2 percent above the value-weighted yield on the collateral
observed one week prior to the loan request
The IMF reserves the right to refuse a loan to a member
No conditions are attached to IMF loans
IMF Funding
The IMF borrows from the discount windows of the Fed and other central banks
IMF borrowings from central banks are 100 percent collateralized by government securities
issued by the government of the lending central bank
Government securities that serve as collateral for IMF borrowings from central banks
are lent to the IMF by its member countries
Other Emergency Lending
IMF, World Bank, IDB, and others would make no other emergency lending available
The Exchange Stabilization Fund would be abolished
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